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Mirror, Mirror

Andrew Dudley follows the Fidelity Advisor way--and

Andrew Dudley isn't trying to make his fund, Fidelity Advisor Intermediate Bond/Instl Fund (EFIPX), the best in its category. Nor is he trying to give his "shareholders the highest income component." But, in the wake of a somewhat stabilizing bear market, and in the midst of the "bonds are king" movement, Dudley is simply following his instincts (along with Fidelity's investment style requirements) to outperform his benchmark, the Lehman Brothers Intermediate Government/Credit Bond Index.

"We do not manage the yield," he says. "But I am trying to deliver second-quartile consistency over a three- and five-year time frame."

Fidelity's principal investment strategies hold true throughout all of its bond funds, and include investing at least 80% of assets in investment-grade debt securities; managing the fund to have a similar overall interest rate risk to its benchmark; maintaining a dollar-weighted average maturity between three and 10 years; hewing to diversified asset allocations; and analyzing a security's structural features and current pricing, trading opportunities, and credit quality of its issuer.

As vice president and portfolio manager for Fidelity Investments, Dudley began managing EFIPX in late 1999. He is also responsible for Fidelity Short-Term Bond Fund, Fidelity Advisor Short Fixed-Income Fund, and Fidelity Ultra-Short Bond Fund. And while dividing his time and his talents among these four funds may seem challenging to some, EFIPX has earned four stars from S&P and five from Morningstar.

"There are no bad bonds, just bad prices," is the motto Dudley says he keeps in mind when reviewing potential investments. The ultimate goal is to create "a balance of both credit and sector allocations."

For the 10-year period ended August 30, 2002, EFIPX had an average annualized total return of 6.6%, versus a total return of 7.4% for the Merrill Lynch Corporate & Government Master Index, and an average annualized total return of 6.6%, compared with a total return of 6.3% for all Intermediate-Term High Quality funds, according to S&P. On a total return basis, this fund ranked 150 within the entire universe of 480 funds in the Domestic Taxable Fixed Income category, and ranks 35 within the entire universe of 125 funds in this peer group.

We spoke with Dudley on September 11 as the lights in his Merrimack, New Hampshire, office temporarily blacked out. "I hope there isn't some big mushroom cloud outside," he said. But as the generators clicked on, he brightened up, relating where his fund fits within its category, Fidelity's management style and investment requirements, and how his benchmark nearly dictates every aspect of this fund.

S&P categorizes your fund as an intermediate-term, high quality fund, and Morningstar categorizes EFIPX as a short-term bond fund. Which is more accurate? The space that this fund lives in is the one- to 10- year maturity space. And that is defined by the benchmark (Lehman Brothers Intermediate Government/Credit Bond Index) that we explicitly line ourselves up against. I find it difficult to categorize this fund as a short-term bond fund. I find the very broad Morningstar category to be a bit misleading. If I had to line it up, I'd go by the risk numbers. Think of it in terms of interest-rate risk; the interest-rate risk on a short-term bond is roughly 1.8 years. Interest-rate risk on this fund is about 3.6, given where interest rates have gone. And the interest-rate risk on the broad-market funds tends to be between four and five years, depending on where the aggregate index is. Just on those numbers alone, it is closer to the aggregate and the broad market products than to the short products.

This fund's inception was in 1984. How has it changed over time, and how have you specifically molded it to your own style? Around 1995 and 1996, all of Fidelity's products took on a very predictable profile that lined up all the funds with a very clean and understandable benchmark. This was done so shareholders could evaluate the risk from an interest-rate and credit-risk standpoint just on the basis of that benchmark. On top of that, keeping in mind a reasonable risk profile wouldn't allow us to stray too far away from what the shareholders thought they were getting in terms of interest-rate risk, credit risk, and repayment risk.

In terms of style, this fund is managed in a very risk-controlled kind of modest incremental strategy. We are managing to a highest total return relative to the benchmark, and that can come in the form of price, or in the form of yield. We're trying to find the cheapest cash flows in the high-grade bond markets. That cuts across not just the credit market, but would include [vehicles] like asset-backed securities, mortgage-backed securities, commercial mortgage-backed securities, Treasuries, and agencies. In a broader sense, we manage within the higher-grade part of the marketplace and have a very strong tradition of bottom-up company-specific research.

My style is simply to create the portfolio within the parameters and the risk tolerance that we identify versus the benchmark, and to deliver second-quartile consistency over a three- and five-year time frame. Since we overweighted the non-Treasury, non-government parts of the market relative to our benchmark, and that's a theme that doesn't go away over time, we are not closet indexers but instead take pretty active sector allocation positioning strategies relative to the benchmark.

What do you look for in a corporation before investing in its debt? Do you simply look at its debt ratings and then buy the duration you want, or do you look hard at the company's fundamentals? Have the corporate accounting scandals changed the way you evaluate a company's debt offerings? While we live by the mandated guidelines that suggest we can't buy something rated below investment-grade in these portfolios, we evaluate the issuers ourselves and do not depend on agencies. In the recent past, we think the agencies have gone "weight overboard." The fact that they had investment grade ratings on Enron and WorldCom two or three months within default is a significant miss. Our evaluation is a combination of company-specific issues and the sector-related environment, the overall industry, and then some evaluation in the context of their valuation in the marketplace. There are securities we buy where the fundamentals were neutral but valuations were good, and there are securities we buy where the valuation was fair but the fundamentals were good. It is not just that I buy the best names; [rather] I try to buy the best names appropriately priced for their risk. If my portfolio was only made up of names like Wal-Mart that trade very tightly on a spread basis to Treasuries, I would have a tough time outperforming despite the fact that the risk of the portfolio would be lower.

That whole line of thinking becomes acute when we have investment-grade companies trading like high-yield companies. We see that as a large opportunity. Overall, large chunks of the corporate bond market have repriced to a level of risk that I think is unrealistic. My job is to take advantage of that in a focused and diversified way.

Your fund had average annual return of 6.5% for the 10 years ended July 2002, compared to 6.2% for all bond funds in your category. Why has your fund performed slightly better? A year to a year and a half ago, on the credit side we started to become a little more focused and take a little more risk in some specific names, but that is only in the wake of this reevaluation in certain parts of the market. Prior to the last six months we had simply implemented a very concerted effort to get more diversified in our credit exposure. We felt the idiosyncratic risk in individual names had grown to levels we couldn't stomach; this means two or three years ago it wasn't uncommon to have 1% to 2.5% in individual names. Over the last two years we moved that to a much more modest positioning, from 0.5% to 0.75%. You could say that that was a modest change. What it meant was that we didn't let any single name blow up the fund or any single name take down the fund, in a way that was out of line with the risks we are trying to take relative to the benchmark. Now that we are in the middle of this period of extreme valuations of individual names, particularly in the subsector of communications, at levels that are relatively extreme for investment grade credits, the diversified fund approach may be less helpful. Now, are we going back to 1.5% to 2% positions? No. But are we stuck to 0.5% positions as the highest number? No. I think you can start to see some allocations begin to get higher. But we are starting to move into names that we think have been overdone, and warrant the higher exposure.

Has there been a big inflow into the fund since the beginning of the bear market? Two years ago, this fund was probably $550 to $600 million-ish across all share types. [At year end 2000, the fund had net assets of $542 million, according to Lipper.] Recently it's up to about $1.15 billion, so it's doubled in size. It's been steady and I think things have picked up over the last six months.

You currently maintain 6% cash holdings. How does this level fluctuate? It's probably a little high at the margin right now. Right now, on a relative basis we have a negative view of the two-year part of the marketplace relative to the five-year part; in order to implement that trade on a duration-neutral basis, we maintain a slightly higher cash balance. The other piece is the fact that flows do continue to be steady, and sometimes I will leave it in cash for a little bit. A comfortable cash number is really 3% or lower.

Are you at all concerned that the bond market is in a bubble at the moment just as stocks were in the past? This is the big picture: the classic shareholder trend is to chase performance and to chase the recent winner. Clearly the extreme example is the aggressive growth in the late '90s, where the last guys in suffered the most pain. I think we'll see nothing like the growth fund debacle of the last couple years, but we may see some smaller version of that. We may even be at the front end, with the way investors have started to pile into bond fund products, and maybe even more specifically government bond fund products. It is remarkable to me how popular bond fund products are, with five-year yields at 3% and two-year yields at 2%. For my money, even now at these depressed yield-levels, you have to take a bigger picture view from a total return standpoint. I am not sure you are maximizing your risk-adjusted returns by just going into government bond fund products. I think a longer-term view would lead you to products like Advisor Intermediate.

You have a significant amount in mortgages, especially Fannie Mae mortgages. In terms of the mortgage performer, these are agency-backed, mortgage-backed securities so there is really very little credit risk. The fact that Fannie explicitly backs it is even better than a Fannie Mae divestiture or street Fannie Mae issue. You also have the collateral of the underlying houses as security for the transaction in a way that you wouldn't on a Fannie Mae agency bond. So it is not just the implicit or explicit backing of the government of Fannie Mae, but also the collateral that exists in these structures that makes them so strong. The real risk is what you take on in terms of the timing of cash flows, and the repayment risks involved in these securities.

Our allocation in mortgages has started to creep up relative to the May-June time frame. We're doing it on a conservative basis on some of the more pre-protected parts of the market that are going to secure us well even if the market gets more volatile again.

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